More Than Good Enough for Government Work

To reform public pensions, policymakers must tackle their structural problems.

State lawmakers face an uphill battle in trying to bring their governments’ pension costs under control, largely due to opposition from government employee unions. But the unions’ resistance to reform is beginning to weaken, and a growing number of states are enacting reforms.

The momentum for pension reform is likely to mount as long as state budget woes persist. And persist they do. Nationwide, public pensions are underfunded by a total of $4.4 trillion, according to Northwestern University finance professor Joshua Rauh.

According to a new report from the National Conference of State Legislatures, “From 2009 through 2011, 43 states enacted major changes in state retirement plans for broad categories of public employees and teachers to address long-term funding issues.” These reforms include increased employee contributions, higher age and service requirements for retirement, less generous cost-of-living benefit increases, and changes in formulas for calculating benefits.

This is a positive trend, but as Rauh’s estimate makes clear, much work remains to be done. If reform is to succeed, it must tackle head-on the following structural factors that caused pension costs to explode in states across the nation:

Structural factor 1: Pension payouts based on final year pay.

Many pension funds set retiree payouts based on the retiree’s final year earnings, rather than a career average. This has enabled some public employees to engage in a practice known as “spiking,” which involves employees racking up long hours of overtime during their last year on the job. Some employees even end up with pension payments that exceed their final year salary!

Unlike the private sector, collective bargaining in the public sector places government employee unions on both sides of the table, as the unions spend huge amounts of time and resources in electing their own bosses.

A recent Los Angeles Times investigation found that even though in 1993 the California Public Employees’ Retirement System (CalPERS) banned spiking, 20 of California’s 58 counties do not participate in the state plan and continue to allow the practice. The Times found that, “In Ventura County, where the pension system is underfunded by $761 million, 84% of the retirees receiving more than $100,000 a year are receiving more than they did on the job. In Kern County, 77% of retirees with pensions greater than $100,000 a year are getting more now than they did before.”

California Governor Jerry Brown recently proposed calculating payouts based on a three-year average of final pay. While a slight improvement, this proposal would still allow spiking to remain viable. For such a reform to have teeth, it should be based on a career average, or at least on a much longer time period.

Government employee unions have a vested interest in the growth of government. More government programs mean more government workers, which in turn mean larger union membership rolls. Membership dues go in large part to campaign contributions to politicians eager to expand government. Unlike the private sector, collective bargaining in the public sector places government employee unions on both sides of the table, as the unions spend huge amounts of time and resources in electing their own bosses.

Once in office, union-friendly politicians naturally seek to keep their union supporters happy. To do so, these elected officials vote to give unionized government employees greater pay and benefits. For politicians eager to please their union supporters while avoiding taxpayer ire, pensions are the perfect tool, as they allow them to kick the can down the road in terms of costs. When the payments come due, they’ll be out of office, and it’ll be somebody else’s problem.

For politicians eager to please their union supporters while avoiding taxpayer ire, pensions are the perfect tool, as they allow them to kick the can down the road in terms of costs.

Many unions and local governments agree to submit to binding arbitration to avoid strikes. However, this can be even costlier than strikes themselves. An arbitrator will never award a settlement that is less than management’s final offer, so the union is guaranteed to win at least some of its demands, and will never come out worse than the status quo ante, thus creating an upward ratchet effect on wages.

Structural factor 4: Politicized pension fund boards.

Overly generous pension commitments have been exacerbated by poor investment management, largely due to politics. CalPERS is a case in point. Despite its commendable ban on pension spiking, the fund’s management is hardly a paragon of sound investing. Even though the California state constitution requires pension fund managers to choose investments to maximize return and minimize risk, CalPERS board members have pursued a political agenda under what it calls a “triple bottom line,” which can include environmental and social objectives unrelated to increasing investment returns. As my Competitive Enterprise Institute colleague Trey Kovacs notes, in 2000, CalPERS stopped investing in tobacco firms, causing the fund to sacrifice $1 billion in potential gains. In 2008, CalPERS lifted its tobacco ban, admitting that it “could no longer justify” it.

U.S. state policymakers should look to the management of public pensions in Canada, which The Economist profiled recently, noting, “Those seeking to understand how Canadians have pulled it off are given two answers: Governance and pay. There is little political interference in the funds’ operations. They attract people with backgrounds in business and finance to sit on their boards, unlike American public pension funds, which are stuffed with politicians, cronies, and union hacks.”

Structural factor 5: Faulty accounting standards.

Many state pension managers base their funding projections on overly optimistic expectations of investment returns, resulting in too little being set aside for future beneficiaries. This has been allowed to happen under rules set out by the Government Accounting Standards Board (GASB), which governs public pensions. GASB rules allow public pension funds to set their liability discount rate based solely on their expected rate of return. For most pension funds, this lies in the 7.5 to 8.5 percent range.

Many state pension managers base their funding projections on overly optimistic expectations of investment returns, resulting in too little being set aside for future beneficiaries.

However, while pension funds can achieve such rates of return in some years, they are extremely unlikely to replicate such performance in the long run and without taking a lot of risk. Thus, such interest rates should not be used to value benefit liabilities that are guaranteed. As Josh Barro of the Manhattan Institute notes, “Those higher returns carry a downside: volatility … In some moments, investments will produce windfalls that far exceed expectations; at other times, as in the period from 2008 to 2009, the funds’ returns will come in far behind.”

In the private sector, the Financial Accounting Standards Board requires pension fund discount rates to reflect investment risk. “For most private-sector pension plans,” notes Barro, “the market-value approach produces a discount rate between 5 percent and 6 percent—noticeably lower than the 8 percent presumed by the public sector.” Notably, Rhode Island’s wide-ranging pension reforms included a lowering of the state pension fund’s discount rate from 8.25 to 7.5 percent. While arguably it could have been lowered by more, the move is a step in the right direction.

Both political parties are to blame for budget deficits. Today, they threaten the fiscal viability of states both red and blue. As the National Conference of State Legislatures report makes clear, state officials across the nation and from both parties are finally working to pull their jurisdictions back from the brink. To do so effectively, they need to enact reforms that tackle structural problems head-on.